Small Business Financial Article
Rich Best has spent 28 years in the financial services industry, as an advisor, a managing partner, directors of training and marketing, and now as a consultant to the industry. Rich has written extensively on a broad range of personal finance topics and is published on several top financial sites. Recent books include The American Family Survival Bible and Annuity Facts Revealed: What You MUST Know Before You Invest.

For Small Business Owners: Better to be SAFE than SIMPLE?

For Small Business Owners: Better to be SAFE than SIMPLE?

For businesses with less than 25 employees, the allure of adopting a SIMPLE IRA as their employer-sponsored retirement plan is very tempting. Simple to set up – just set up an IRA for each eligible employee; and there is no administration. The required matching contribution is only 3 percent, and only on actual salary deferrals.  It’s a quick and easy way to satisfy the obligation employers feel towards their employees as well as themselves to provide an important and generally expected benefit. However, for some employers, especially those which are top-heavy with highly compensated employees, it would be important to look beyond the simplicity and lower cost of a SIMPLE IRA to consider their limitations as well as the advantage of alternative plans, such as a Safe Harbor 401k.

In addition to cost, employers need to consider the plan’s deferral limits, eligibility requirements, required contributions and its flexibility in light of their own objectives, the company’s objectives, the demographics of the business, and their business outlook.  When considering each of these parameters, employers may not want to be too quick to jump into a SIMPLE IRA, simply because of its limitations and requirements:

  • The maximum salary deferral is $13,500 (2020) or $16,500 for employees age 50 or older.
  • Eligibility extends to any employee who earned more than $5,000 in the prior two years (which would include part-time employees).
  • Although it does allow a matching contribution of at least 3 percent, no other contributions may be made on an employee’s behalf.
  • Once a SIMPLE plan is adopted, no other plan can be adopted during that plan year.
  • After terminating a SIMPLE plan, no other plan may be established until the next year.

The Advantages of a Safe Harbor 401k Plan

It should be stated right up front that a Safe Harbor plan is more expensive to establish and administrate; however, in the right circumstances, the benefits will far outweigh the costs.

Greater Flexibility

Generally, the Safe Harbor plan is more flexible than other plans, which may be important for smaller businesses that experience a lot of change and growth in their early stages. Plans can actually be stopped and started in any given year depending on the employer’s circumstances at the time. Also, because it is built on a profit-sharing structure, profit-sharing contributions, which are discretionary, can be determined each year.

Higher Deferrals and Contributions for Highly Compensated Employees

The employee contribution limit for Safe Harbor 401k plans in 2020 is $19,500 (plus $6,000 catch up for employees over 50). However, employers may contribute up to 25 percent of earnings up to $57,000 ($63,500 for employees over age 50), which includes the profit-sharing component.

Tax and Cash Flow Management

The profit-sharing component is determined each year, and employers can wait to make the contribution until the actual due date of the tax return. This affords employers the opportunity to optimize cash flow.

Stricter Eligibility

Although the minimum required matching contribution is higher than a SIMPLE plan (4 percent vs. 3 percent), under Safe Harbor plan rules, employees are not eligible until age 21 and have worked at least 1,000 hours in their first 12 months of employment. Because eligibility is determined on either January 1 or July 1 of the following year, many part-time and seasonal employees won’t become eligible for the plan or any profit-sharing allocation. As with the SIMPLE plan, matching contributions are only made on actual salary deferrals.

In addition, any profit-sharing contributions made to lower-paid employees are subject to a 6-year vesting schedule which means only 20 percent is vested each year beginning with the 2nd year and only in years in which the employee works more than 1000 hours.

Of course, there are several factors that need to be considered, including the cost which can run around $2,000 for plan setup and about $1000 a year for administration (in addition to a nominal per-participant fee, i.e. $30). However, if there is at least one other eligible employee aside from the employer, the plan qualifies for a $500 tax credit during the first three years. But, for the substantially enhanced benefits to the employer and its highly compensated employees, it may be better to be SAFE than SIMPLE.

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